Next stop, stagflation?

Parmenion Investment Management

Stagflation is a poisonous mix of slow growth, inflation and unemployment. What causes it, and how to deal with its effects, divide opinion among professional economists. It gives central bankers and policy makers a severe headache and because it is difficult to combat, stagflation builds anxiety and uncertainty in financial markets, which is bad for investors.

Governments and central banks have several reliable tools to combat more common economic scenarios, whether these tools are fiscal (spending and taxation) or monetary (interest rates and QE). For example if inflation is spiralling out of control, interest rates can be increased to reduce consumer spending, consequently taming the level of inflation.

stagflation builds anxiety and uncertainty in financial markets which is bad for investors

But stagflation exhibits a combination of economic indicators, individually manageable, but which as a group are a minefield for decision makers, given that one problem’s cure is another’s catalyst. Rising inflation, slowing growth and increasing unemployment are not a logical blend, which is why stagflation is so confusing to deal with.

Both economic and political uncertainty have been the key recent themes, stealing column inches on a daily basis following the UK’s decision to leave the EU on 23 June. Markets take uncertainty particularly poorly. Growth forecasts have been scaled back significantly for 2016 and 2017 on the back of a predicted severe contraction in corporate investment activity. As our chart indicates, sterling felt the pain severely after the vote, falling to its lowest level against the dollar for over three decades. This is likely to lead to increased energy prices and import costs and consequently a rapid increase in “cost push” inflation, which has been non-existent for so long.

Lastly, the UK’s unemployment rate is likely to increase as businesses hold back not just on physical investment but also committing to hiring, until greater clarity can be found over the UK’s future trading position.

With each of these factors in mind, stagflation is a real concern for the UK and combatting it will not be an enviable task.

StagflationGBP/USD Exchange Rate

If stagflation does take hold, it will seriously test our policy makers’ skill and creativity. It will be interesting to observe whether the Bank of England chooses to look through the inevitable “cost push” inflation which will follow the fall in sterling and if so how much pain from rising prices they can stomach.

It appears that uncertainty will be a continuing theme for some years to come. Political risk has receded, because the swift appointment of a new leader means the UK has avoided months of uncertainty, had a Conservative leadership contest taken place. But the next big political challenge is coming up fast, as negotiations must soon begin with the EU. This will clearly be a prolonged and complicated process.

Political risk has receded, because the swift appointment of a new leader means the UK has avoided months of uncertainty

Times of stress call for a sensible and pragmatic approach to investment management and portfolio construction, with diversification at the heart of any winning, workmanlike solution. We will be looking to maintain our well established, long term investment focus and will not be tempted into any knee jerk reactions, waiting for the dust to fully settle before acting, and never taking any ill-considered risks.

The above article  by Harry Garrett, Investment Analyst at Parmenion Investment Management, was first published by Parmenion Investment Management on 19th July 2016